Why corporate profits sank in first quarter and what it means

After-tax corporate profits sank 13.7% in the first quarter to mark the second biggest decline in the past 50 years, using a number that adjusts for depreciation and the changing value of inventories. Reason to worry companies will slash hiring and investing? Probably not. Read: U.S. economy contracted 1% in the first quarter

For one thing, corporate profits remain close to an all-time high. The decline in earnings in the first quarter follows record levels in the third and fourth quarters of 2013.

The drop in earnings, what’s more, was probably exaggerated by the end of a special tax break that allowed companies to write off the value of investments at a quicker pace. So companies were unable to use as many deductions and paid higher taxes in the first quarter.

Looked at another way, corporate profits in the first quarter after companies paid taxes only fell by a small amount. This unadjusted number – what companies show publicly in their profits reports– slipped to an annual rate of $1.88 trillion from a record $1.90 trillion in the 2013 fourth quarter. That’s just a 1.3% drop.

What’s more worrying is the lackluster pace of business investment despite such high profits. Since the recovery began in mid-2009, investment on equipment such as computers or heavy machinery as a percentage of gross domestic product has averaged just 5.2%.

By contrast, annual spending in that category averaged 6% during the economic expansion from 2001 to 2007, and an even larger 6.8% during the long boom from 1991 to 2001. While the difference might seem small, that amounts to tens of billions of dollars of investment that can boost hiring and even lead to higher wages for American workers.

Hopes for faster growth in the second quarter and beyond rest on the idea that businesses will soon increase investment. And there’s some evidence to suggest that might start to happen. Neil Dutta, head of economics at Macro Rennaissance Research, points out that spending on research and development has risen 5.7% over the past year. That’s the fastest pace since the end of the Great Recession. R&D typically rises ahead of business investment in other areas.

On the other hand, companies have spent large sums over the past few years on stock buybacks and higher dividend payments, perhaps a sign they don’t think they’ll generate a sufficient return on increased investment.